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Understanding Variable Annuity Investments

With the global economic depression taking its toll on many Americans' finances, people are increasingly searching for new ways to ensure a comfortable retirement. Variable annuities are proving to be one of the more popular options, and although most are at least vaguely familiar with the concept, very few are closely acquainted with the many pros and cons of variable annuities, from their relation to fixed annuities to their taxation.

What is a variable annuity?

While precise definitions differ depending on the particular annuity, variable annuities can be briefly described as contracts made between an individual and an insurance company which adumbrate a scheme of periodic payments made by by the insurance company that may begin immediately or at a predetermined later date. Such annuities may give rise to a range of investment options, with the value of the variable annuity being largely dependent on the performance of the investments you opt to make. Although certain plans may differ, investment options for variable annuities generally consist of mutual funds investing in some balance of stocks, bonds and money market instruments.

It is important to note, however, that while variable annuities are most commonly invested in mutual funds, the two bear certain key differences. Variable annuities, for instance, provide a safeguard against the possibility that you may outlive your assets in allowing you to receive periodic payments throughout your life or that of your spouse or other designated party. Furthermore, variable annuities offer a death benefit, a feature which guarantees your beneficiary's receipt of an amount at least equal to that of your purchase payments in the event that you pass away before the insurance company has begun to make the transfer of payments.

Variable annuities typically consist of two phases: the accumulation phase and the payout phase. The former of these is the period in which you make the purchase payments, the value of which you may designate for various investments. You may, for example, choose to dedicate thirty percent to a U.S.-based stock fund, forty percent to an international stock fund and thirty percent to a bond fund. As with all such investments, the value may increase or decrease over time depending on the performance of the fund. There is also the option of directing a portion of your purchase payments to a fixed account. Unlike a standard mutual fund, a fixed account pays a fixed rate of interest. While insurers may on occasion reset the rate, they will generally state a guaranteed minimum, typically around three percent per annum.

Prior to deciding upon a variable annuity, it is key to scrutinize the insurer's prospectus detailing the annuity's different investment options. By analyzing a fund's investment objectives and carefully weighing their management fees and related fund charges as well as the fund's recent volatility you can gain an insight into the likelihood of strong, solid performance. As always, it is also worth noting whether or not the fund helps improve the diversity of your portfolio.

In the accumulation phase you are generally permitted to move money among investment options without being taxed on your investment income, although you should be aware that certain insurers will likely impose a fee for such transfers. Additionally, you may be penalized with what is known as a "surrender charge" if you choose to withdraw money from the account early in the accumulation phase. There is also the possibility of being charged a ten-percent federal tax penalty for withdrawals made before the age of fifty-nine and a half.

On reaching the payout phase you may choose to take your purchase payments plus any investment income and gains in the form of a lump-sum payment, or you may opt to receive a series of payments, usually issued monthly. If you decide upon the latter, you will be faced with a number of subsequent choices as to the length of the payment period. Most variable annuity contracts will allow you to specify either a set period (fifteen years, for example) or an indefinite period (for the rest of your life or that of your beneficiary, for example).

You will also likely have the option to receive payments of a fixed sum or payments which are dependent on the performance of your mutual fund investments. As you would imagine, the value of each payment is determined primarily by the length of the payout period. It must be borne in mind that once you have adopted such a payout structure, it may not be possible to withdraw money not already scheduled to be transferred to you. Those concerned that the delay between the beginning of the accumulation phase and that of the payout phase will be problematic may favor an immediate annuity, in which annuity payments begin as soon as money is deposited, effectively obviating the accumulation period.

What are the advantages and disadvantages of a variable annuity?

With the basics of variable annuities established, it's worth undertaking the classic exercise of outlining the pros and cons in order to determine if a variable annuity is right for you. The advantages of variable annuities are numerous, but for many their chief attraction is that the lack of restrictions on how much you may contribute to them in any given year. Where other standard retirement plans, notably IRAs and 401K plans, are subject to restrictions, variable annuities allow unlimited contribution, rendering them perfect for those who are unhappy with the annual limits that moderate deposits in other such schemes.

Another key benefit of a variably annuity is the death benefit, the aforementioned rider that guarantees that your spouse or beneficiary will receive a certain sum of money should you die prior to the completion of the contract. Variable annuities will generally pay out one of two amounts in such event, which is either your initial investment sum or that same sum plus a predetermined amount of interest given to them each year. That said, if your investments have already paid out more than the guaranteed minimum, the death benefit rider will not be applicable since your spouse or beneficiary will receive your account's full amount.

The guaranteed income benefits are another of the major advantages of a variable annuity, with the guaranteed minimum income benefit, or GMIB, the most common of these. The GMIB dictates that you receive guaranteed payments irrespective of current market conditions but allows you to benefit from increased revenues in times when the market is more robust. The guaranteed minimum income is an attractive feature for many who opt for a variable annuity, and one that is not shared by many similar investments.

Investors may also exploit the guaranteed lifetime withdrawal benefit, or GLWB. This rider, which can be taken advantage of only during the accumulation stage, guarantees a basis of withdrawal which is equal to the amount of the initial investment plus an annual interest credit usually somewhere between six and seven percent. On beginning to receive the income, however, you are still entitled to an increase in your monthly payments if the market fluctuations are favorable.

Although not a feature common to all variable annuity accounts, those that offer tax deferral are valued more highly by investors. It is a firm rule of investment that any security that is subject to annual taxation is inferior to one for which the option of tax deferral is available. While annual taxation may not on first sight appear to be such a limitation, it must be kept in mind that most investors do not cover these tax bills by redeeming shares in their mutual fund, but by making the payment from a separate account.

There are, of course, a number of possible drawbacks to variable annuities, chief among which is the IRS annuity penalty. Any income withdrawn from a variable annuity prior to reaching the age of fifty-nine and a half will result in a ten-percent IRS tax penalty. This fine was instituted with the intention of forcing investors to view their variable annuities as long-term savings plans rather than as traditional investments. Of course, some may be forced to access their money in times of need, and in such instances the ten-percent tax can be an inconvenience, or worse.

In most investments, the potential loss of capital is an ever-present danger, although such is less of a concern with variable annuities than with fixed annuities, certificates of deposit or money market accounts. With your initial deposit being invested in equities, however, there is always the risk that a portion of your money can be lost in the event that the equities depreciate in value.

Variable annuity taxation is another potential negative for those considering such an investment. As previously mentioned, while variable annuities are not immediately subject to taxation, there will inevitably come a time when the annuity will be taxed at standard income rates. In contrast with stock market gains, income from variable annuities is not deemed to be capital gains, and accordingly the surplus tax will be in proportion to the capital gains tax rate at that particular time. Still, many feel that the ability to defer taxation is a sufficient advantage to counterbalance standard variable annuity taxation.

Consult any group of variable annuity investors and you'll undoubtedly hear gripes concerning the withdrawal charges. Insurance companies are always inclined to keep your money invested for as long as possible, and consequently they impose such penalties as a means of dissuasion. Requesting a withdrawal which exceeds the limit allowed by the contract, then, may expose you to fees of up to ten percent. Such limits typically range from five to fifteen percent, and for larger variable annuities this can result in hefty charges for those wishing to withdraw a significant sum of money.

Another hidden cost of variable annuities is in the management fee, which may be as low as one percent and as high as four, or roughly the amount you would expect to pay in fees for a CD. This sum is split evenly between the brokerage house in charge of your portfolio and the insurer itself. While such fees are generally offset by strong long-term performance, they remain a black mark against variable annuities for many. Likewise, the other contract fees that may appear are minor but nonetheless unwelcome. Some insurance companies, for example, will routinely charge between twenty and forty dollars a year for administrative costs, which one might otherwise imagine would be covered by the management fee.

What are the tax laws regarding variable annuities?

Certain aspects of variable annuity taxation have already been touched upon incidentally, but there are certain tax minutiae which may render variable annuities more or less appealing depending on your specific circumstances. As mentioned previously, one of the great advantages of variable annuities is that their gains are not subject to annual taxes, and provided that you do not withdraw the money until you reach the age of fifty-nine and a half the ten-percent tax penalty can be avoided entirely. When money is withdrawn it is considered ordinary income, and the distributed amount will be followed by a 1099-I form.

In the case of a variable annuity, the cost basis is the principal amount, namely the money used to fund the account. Depending on the particular structure of an account, the cost basis is regarded differently. A non-qualifiable variable annuity, for instance, is effectively a retirement account for which the basis is after-tax money. Given that investors have already paid the appropriate taxes on the principal amount used to fund the variable annuity, no further taxes are imposed on distribution. Qualified annuities such as employer pension plans or IRAs, conversely, are funded with pre-tax money, and accordingly their distribution is deemed to be ordinary income.

As noted above, the value of a variable annuity increases and decreases in step with the mutual fund assets into which the money is invested. Although the mutual funds may generate capital gains and losses each year, such is not the case with the variable annuity itself. Accordingly only distributions are taxed, and even then at an income rate rather than at a capital gains rate.

Are annuity guarantees worth it?

Having already discussed the various annuity guarantees offered by insurance companies, it is important to address the question posed by many financial experts: Are they worth it? While once they were almost universally viewed positively, nowadays opinion is somewhat more divided on the value of variable annuity guarantees. Such a drastic shift in opinion was catalyzed by the new contracts introduced on May 1, 2009, when many of the major insurance companies reduced their guarantees while increasing the associated fees. Indeed, a study carried out by Ernst and Young's Retirement Income Knowledge Bank discovered that between December 2008 and May 2009 eighteen of the top twenty insurers offering variable annuities altered their guarantees.

If the GMIB described previously sounded generous, it's because it was. In fact, the downturn in the market saw ratings agencies downgrading insurers on the basis of their overly generous guarantees, leaving them open to the possibility of having to make significant payouts to to holders of annuities which had performed poorly. Consequently, a number of insurers both raised their fees and limited the scope of their guarantees on May 1, 2009. Such changes included dropping the guarantee on the initial investment from six percent to five percent, also restricting the range of funds into which their annuity holders can potentially invest to eliminate certain of the more unpredictable choices. Furthermore, some insurers now oblige their annuity holders to maintain at least a fifth of their investment in a fixed account, and have raised fees which were previously as low as 0.6 percent of the initial investment to up to 1.25 percent.

Those, of course, are the changes undertaken by the insurers which continued to offer such guarantees, with about a dozen scrapping variable annuity guarantees entirely. These and related changes mean that annuity guarantees are becomingly an increasingly unattractive option to investors, with those who managed to secure favorable guarantees prior to May 1 clinging tightly to their policies.

Which insurer offers the most attractive variable annuities?

Even in a field as number-oriented as finances, there is unfortunately no objective answer to such a question. Depending on your financial circumstances, your age, the sum you wish to invest and when you intend to begin withdrawing money, a range of different insurance companies may prove to be your best option. That said, as financial institutions, insurers can fairly be judged to some extent on their current and historical performance in the financial arena in general. While such is perhaps not as crucial for variable annuities as it is for other traditional investments, a company's overall performance remains a key indicator as to how it will perform for you in particular. What's more, given that the insurer is tasked with funding parts of the annuity itself, a financial downturn that weakens the company may threaten your funds also, and a such it is crucial to invest your money in a stable brand.

Although the insurance companies offering variable annuities are too numerous to detail here, you are likely to find an annuity that suits your needs among the handful of insurers that follow.

John Hancock Financial
As one of the foremost brands in U.S. finances, John Hancock Financial has proven a reliable institution. Currently owned by the Canadian Manulife, itself the fourth-largest insurer on the planet with a market capitalization estimated at sixteen billion dollars, John Hancock is among the most highly regarded of all insurers according to the four major rating services, whose rankings are listed below.

ING
While the leviathan financial institution hailing from the Netherlands may be better known to many for other investment and retirement services, they are a key player in the insurance market, as evidence by their ten-billion-dollar market capitalization, making them the ninth-largest life insurer worldwide. Like John Hancock, they are consistently ranked among the top insurance companies.

Metropolitan Life Insurance Company
The pervasive MetLife brand may be recognizable for its shrewd marketing as much as for its financial performance, but it justifies its recognition with a fourteen-billion-dollar market capitalization, trailing behind only four other insurers in the world.

Jackson National Life Insurance Company
The eighth-largest insurer worldwide with a market capitalization of over ten billion dollars, Jackson National is a wholly-owned subsidiary of Prudential PLC of England. Jackson National has been consistently solid, with rankings that reflect such dependable performance.

New York Life Insurance Company
Far and away the best reviewed of all the American life insurance companies, New York Life also bears the distinction of being the largest. Enjoying the highest rankings from A.M. Best (A++), Moody's (Aaa), Fitch (AAA) and Standard & Poor's (AAA), its reputation is unparalleled among the major insurers. While reputation alone is not reason enough to select an insurer, it certainly helps to inspire confidence, and such rankings do just that for New York Life.

With such information at your disposal along with that provided by individual insurers, you will be better informed as you make a decision as to whether or not to invest in a variable annuity. To recap, there are a number of factors that must be kept in mind as you weigh variable annuities against other investments, and individual annuities against one another. If you are mulling an investment in a variable annuity, it may be useful to consider the following questions as you decide where your money will be going.

How does a variable annuity match up to other investments for me? Are there alternatives which would be more expedient given my current and anticipated future circumstances?

Would a fixed annuity be more suitable for me?

Are the tax laws concerning variable annuities a positive or a negative for me?

Should I consider a plan with guarantees? If so, which guarantees should I look for?

Which insurer is right for me?

By posing these questions and others relating more specifically to your circumstances, you can be confident of making a profitable decision when considering a variable annuity.